The false sense of security into which the current lack of market volatility is lulling many investors has been a recurring theme on The Value Perspective in recent months – and neither is this limited solely to stocks and bonds. As you can see from the graph below, by mid-July currency-market volatility had reached its lowest level this century and was standing at almost half its long-term average.
Source: CVIX, as at 26th august 2014.
In the same way the Chicago Board Options Exchange’s ‘VIX’ index measures the implied volatility of the S&P 500 index in the US, Deutsche bank’s ‘CVIX’ index offers an indication of the market’s expectations of future currency volatility. As such, like the VIX, the CVIX can be used as a benchmark to gauge investors’ appetite for risk-taking.
The CVIX is calculated based on the implied volatility of nine of the world’s most important currency ‘pairs’ – Sterling/US dollar, US dollar/Euro, Euro/Yen and so forth. It therefore follows any action taken by world central banks – and especially the bank of England, the US Federal Reserve, the European Central Bank and the Bank of Japan – is likely to have a significant bearing on the index.
However, while it is tough to deny the looser monetary policy of the world’s central banks over the last five or six years has reduced some of the risks companies face in terms of financing themselves, it does not necessarily follow it should also have reduced the risk or the differences in futures of different currencies and markets around the globe.
To put it another way, would you expect the looser policy of recent years to mean the relationship of the US dollar and the euro, say, is going to be less or more volatile in the future than it has been in the past – not least given the market’s expectation the fed will start raising interest rates at some point next year while the ECB may keep its own monetary policy loose for some time yet?
Even if that were not the case, there are all sorts of reasons why problems could persist in the US and why problems could persist in Europe. The present unusually low implied volatility of currency markets seems likely to be an outcome of easy policy and people being somewhat complacent about the risks of the future just because things are easy today.
But that is the trouble with volatility – it is an inherently backward-looking measure and those who use it to justify a belief that easy monetary policy has destroyed some historically very long-term divergences in different currencies should probably focus less on what has happened in the past and more on what could be round the corner.